We've documented here in the past the dangerous embedded in this current low volatility environment.
If there is a volatility blow up, it is easy to imagine how easily things can snowball out of control.
With that said, one of the areas not covered in minute detail is the prevalence of inverse VIX ETFs.
Before getting into that, here is some free promotion for Nassim Taleb's Fooled By Randomness and Black Swan books.
In one of the books (can't remember which one), Taleb pompously explains the simple concept pertaining the flaws of logic, the dangers of using specific incidences to reach general conclusions. One variant of this is using the past to predict the future. Amidst his grandiose and philosophically ridden text is quite a simple and down to earth example.
There is a turkey who is fed and taken care of until it is Thanksgiving time. If one was to chart the wellbeing of a turkey through this course of events, it would go something like so:
Now, when my parents heard I was trading my own money (back in undergrad...ah...those were the days), they frequently asked me whether I can lose everything in one day (they've heard the folktales and war stories of market-on-participant violence). I repeatedly said "No!".
Even during the most violent market crashes, there are a number of opportunities for non-institutional participants to get out. 1987 is the example of the most violent and immediate market crash I personally know. Even then, market participants with a nose for market timing had a few chances to exit the market with relatively mild losses or even be able to profit.
Then came 2017 and the prevalence of inverse VIX ETFs. Let's read a description excerpt from one of these bad boys.
The investment seeks to replicate, net of expenses, the inverse of the daily performance of the S&P 500 VIX Short-Term Futures index. The index was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve.
That statement brings up some intriguing questions.
What happens when, in one session, the VIX increases by 100% or more?
Has that happened?
What happens to inverse VIX ETFs?
What if the VIX increases by 50% or more - what happens to levered positions on inverse VIX ETFs? etc. etc.
First, has it happened?
I looked at two different volatility gauges - the VIX directly and the older VXO (volatility for S&P 100) indicatively. Clearly, there is little that bounds these volatility gauges from appreciating upwards of 100% on a daily basis.
In fact, here are the times in history (of data available to me) when you would've gone bust holding these inverse VIX ETFs, if they existed in the past. I looked at both daily returns (prev day close vs next day close) and intraday returns (prev day close vs next day high).
I looked at scenarios with 0 leverage, 2x leverage and 3x leverage (believe it or not, I know of retail participants trading inverse VIX ETFs on leverage). I crunched some numbers and built a matrix with the 25 biggest return days in each scenario for each instrument. Times, when one would go bust, are in bold. Calculations are indicative as I am looking at spot VIX.
So yes, it's possible to go bust when these volatility gauges spike, especially when levered.
What will those ETF instruments do when they should be down 100% or more?
From reading the prospectus it seems that an event of a spike in volatility occurs, it would be an "Acceleration Event" defined as:
...any event that adversely affects our ability to hedge or our rights in connection with the ETNs, including, but not limited to, if the Intraday Indicative Value is equal to or less than 20% of the prior day’s Closing Indicative Value.
where the manager of the ETF will liquidate its assets and have the proceeds (if any) distributed.
It's almost as if Nassim Taleb specifically built an instrument to illustrate his turkey concept.
What about the larger market impact?
From my digging, there seemed to upwards of 2.5 billion dollars invested in different VIX funds, mostly short vol in the form of XIV.
Although 2.5 billion dollar seems small in the grand scheme of an entire financial market. It is still a sizable amount held by retail that can potentially disappear into thin air.
Yield enhancement of a portfolio is all well and fine but there are ways to do it, and ways not to do it. There are also times to do it, and times when you shouldn't. Something to chew on.
I assume not too many Macro-Man readers are collecting nickels via these inverse VIX ETFs at this point of the market cycle. But if you are, congrats on the money you've piled up - and you should probably reduce positions to an amount you're okay with, if it evaporates in a day's time.
Short oil. There are a few tidbits regarding oil that has prompted me to cover Thursday. First Venezuela is a mess and there is the possibility that no oil comes out of the country. This is a concern for a short like me, as they are a huge global oil producer.
Additionally, higher US rates scare me as they can put meaningful pressure on US producers, which can lead to a reduction of supply.
Thirdly, the chart's just not cooperating for oil - seems to be making a bottom.
Lastly, perma-bull Andy Hall threw in the proverbial towel a week ago. I know it's anecdotal, but I think it speaks volumes regarding this market's sentiment.
Even if the oil market goes lower, there will probably be an easier time to go back short - when it feels less like I am fighting the market.
Short equities, we have seen the rally that I believed was in the cards - now will tech top out at this potentially lower high? I loaded up on an even bigger position Thursday. Will be either vindicated or stopped out within the next three sessions.
Long USDJPY. Unlimited. Bond. Purchases. If JGB yields rise with the rest of the world's duration, then the BOJ has to buy more. The more the BOJ owns, the less liquidity that market will be and the more broken that market will become (just ask any bond trader).
A reflexive process can potentially take hold here: the weaker the Yen becomes, fewer participants who are not mandated to hold JGBs will want to own them (not to mention less liquidity in the market). The less they want to own them the more they will want to sell. The more they will sell means that the BOJ will have to print more Yen to buy JGBs and also coincidentally make JGBs less attractive vis-à-vis the currency and also killing the market's liquidity.
So how much Yen will the BOJ have to print in order to buy an asset that most will not want to own? I don't know but probably a lot. Probably moar.
For all the commodity heads who follow the blog - look out for an upcoming softs post. Soft commodities, especially cocoa, are starting to look very interesting from the long side.
Thanks all, as always, good luck out there.